Photo credit: diedoe
In a previous post we discussed the general information surrounding Designated Roth Accounts (also known as a Roth 401k) – eligibility, tax treatment, and contributions. In this post we’ll go over the nuances involved in distributions from a Designated Roth Account under a 401k. Distributions are a little different from most other retirement plans, as you’ll see…
Required Minimum Distributions
One of the first things that is different about Roth 401k distributions is that the Required Minimum Distribution (RMD) rules DO apply to these accounts. This is different from the Roth IRA, as RMDs are not required by the original owner under present law. RMD for a Roth 401k are the same as the RMD rules for all other accounts to which the RMD rules apply.
There is, however, a way to get around the RMD rule: if you roll over your Designated Roth 401k account balance to a Roth IRA, RMDs no longer apply. Obviously this is a tax-free event, since both accounts are non-taxable in both contributions and earnings. As long as this is done before the first year of RMD, these rolled over funds will never (under current law) be subject to RMD rules to the original owner of the account. When inherited, Roth IRA and Roth 401k funds are subject to RMDs as inherited accounts – but that’s a topic for another day.
Qualified Distributions
Another difference for the Designated Roth 401k account is in the definition of qualified distributions. As with other retirement accounts, qualified distributions can occur when one of the following events occurs:
- account owner reaches age 59½; or
- account owner dies; or
- account owner becomes disabled (per IRS definition).
In addition to one of those events, in order for the distribution to be qualified (and therefore tax-free), the account must have been in existence for at least 5 years.
Non-Qualified Distributions
A non-qualified distribution is, as you might guess, when the rules for a qualified distribution (above) have not been met. Of course, there are complicated rules associated with any non-qualified distribution from a Designated Roth account.
Pro Rata Rule for Non-Qualified Distributions
A pro rata rule applies (instead of the ordering rules that apply to Roth IRA accounts) for non-qualified distributions from a Roth 401k. For example, if the account had received contributions of $5,000 and had grown to $10,000, when a distribution occurs before the account has been in existence for 5 or more years, 50¢ of every dollar will be taxable. This is different from the rule associated with a rollover, as you’ll see.
Ordering Rule
Just to confuse matters, when rolling over a portion of a Designated Roth 401k account to a Roth IRA in a non-qualified distribution, the ordering rules do apply, so that the first portion rolled over is the taxable amount (the earnings). If the rollover was a qualified distribution, all amounts are considered basis in the new account, and therefore non-taxed upon a qualified distribution.
Rollovers
Now, let’s see how the IRS has really muddied the waters: when rolling funds over from an existing employer to another employer’s Roth 401k – it’s a straightforward activity if you do a trustee-to-trustee transfer – same as for a transfer to a Roth IRA. However (and there’s always a however in life, right?) if you do a non-qualified 60-day rollover things really get complicated.
Complications With a 60-Day Rollover
Here’s what happens with the 60-day rollover to a new employer’s Roth 401k plan: first of all, only the growth (or earnings) from your old employer’s plan can be rolled over to your new employer’s Roth 401k plan. In addition, the earnings portion of the account will be subject to mandatory 20% withholding, even if you roll the entire amount into the new employer’s plan, which should be a tax-free event.
Here’s an example: your Roth 401k account has $20,000 in it, of which $5,000 is earnings. You decide to roll over this account to your new employer’s Roth 401k plan. If you don’t do a trustee-to-trustee transfer, you will only be allowed to put $5,000 (the earnings) into the new account. When you take the distribution, you’d receive a check for $19,000, which is your $15,000 basis plus the $5,000 earnings minus 20% ($1,000) mandatory withholding tax. You are allowed to put up to $5,000 into the new plan, plus up to $15,000 into your Roth IRA, all tax free, even though you were forced to have $1,000 withheld.
Of course, that amount that was withheld will be available to you as a credit against your tax obligation at the end of the year, or as a refund if it caused an overpayment.
If you did a trustee-to-trustee transfer, none of this withholding or earnings-only limitation would have applied, so it makes good sense to do the trustee-to-trustee transfer whenever possible, to avoid such a situation.
5-Year Rule
Rollover To Another Roth 401k or Roth 403b
The last nuance about Designated Roth 401k accounts covered here is the 5-year provision and how rollovers affect it. If you do a trustee-to-trustee (either qualified or non-qualified) rollover of funds to a new employer’s Roth 401k account, the “5-year” starting date will follow from your original account – or rather, whichever account was established earlier will apply to those funds going forward.
On the other hand, if you do a 60-day (again, either qualified or non-qualified) rollover to a new Roth 401k, the age of the new account will apply, even if the funds had been in the old Roth 401k for a significant period of time. Only the taxable or earnings component will be allowed to rollover in a 60-day rollover, so the age of the account is a moot point.
Rollover to a Roth IRA
For the same situations as in the paragraphs above, but the transfers are to a Roth IRA, no matter what kind of rollover is done, direct (trustee-to-trustee) or 60-day, qualified or non-qualified, the results are the same – the 5-year holding period will be that of the receiving Roth IRA account, no matter how long the funds had been held in the Roth 401k account. However, each individual conversion or rollover to a Roth IRA has its own 5-year period, separate from the first 5-year period. See the article Two 5-year Rules for Roth IRAs for more details on this nuance. This is a good reason to establish a Roth IRA immediately, to have a vehicle to receive such transfers if the situation arises.
The one wrinkle with rollovers into Roth IRA accounts has to do with taxability of the rolled over funds: If the distribution is qualified, then all of the funds rolled over are considered basis, and when distributed for any reason the basis is tax-free (no matter the holding period). If the distribution is non-qualified, the funds retain their original characterization from before the rollover – part is contributions (basis) and part is earnings (taxable until qualified).
So you can see some of the great benefits of doing a trustee-to-trustee transfer over the 60-day transfer – especially if the rollover is to be non-qualified. As always, consult your financial advisor before doing any of these, just to make sure you don’t make a mistake!